In an ideal world, portfolio investing is all about comparing the returns available among the three liquid asset classes–stocks, bonds and cash–and choosing the mix that best suits one’s needs and risk preferences.

In the real world, the markets are sometimes gripped instead by almost overwhelming waves of greed or fear that blot out rational thought about potential future returns. Once in a while, these strong emotions presage (where did that word come from?) a significant change in market direction. Most often, however, they’re more like white noise.

In the white noise case, which I think this is an instance of, my experience is that people can sustain a feeling of utter panic for only a short time. Three weeks? …a month? The best way I’ve found to gauge how far along we are in the process of exhausting this emotion is to look at charts (that is, sinking pretty low). What I want to see is previous levels where previously selloffs have ended, where significant new buying has emerged.

I typically use the S&P 500. Because this selloff has, to my mind, been mostly about the NASDAQ, I’ve looked at that, too. Two observations: as I’m writing this late Tuesday morning both indices are right at the level where selling stopped in June; both are about 5% above the February lows.

My conclusion: if this is a “normal” correction, it may have a little further to go, but it’s mostly over. Personally, I own a lot of what has suffered the most damage, so I’m not doing anything. Otherwise, I’d be selling stocks that have held up relatively well and buying interesting names that have been sold off a lot.

What’s the argument for this being a downturn of the second sort–a marker of a substantial change in market direction? As far as the stock market goes, there are two, as I see it:

–Wall Street loves to see accelerating earnings. A yearly pattern of +10%, +12%, +15% is better than +15%, +30%, +15%. That’s despite the fact that the earnings level in the second case will be much higher in year three than in the first.

Why is this? I really don’t know. Maybe it’s that in the first case I can dream that future years will be even better. In the second case, it looks like the stock in question has run into a brick wall that will stop/limit earnings advance.

What’s in question here is how Wall Street will react to the fact that 2018 earnings are receiving a large one-time boost from the reduction in the Federal corporate tax rate. So next year almost every stock’s pattern in will look like case #2.

A human being will presumably look at pre-tax earnings to remove the one-time distortion. But will an algorithm?

–Washington is going deeply into debt to reduce taxes for wealthy individuals and corporations, thereby revving the economy up. It also sounds like it wants the Fed to maintain an emergency room-low level of interest rates, which will intensify the effect. At the same time, it is acting to raise the price of petroleum and industrial metals, as well as everything imported from China–which will slow the economy down (at least for ordinary people). It’s possible that Washington figures that the two impulses will cancel each other out. On the other hand, it’s at least as likely, in my view, that both impulses create inflation fears that trigger a substantial decline in the dollar. The resulting inflation could get 1970s-style ugly.

My sense is that the algorithm worry is too simple to be what’s behind the market decline, the economic worry too complicated. If this is the seasonal selling I believe it to be, time is a factor as well as stock market levels. To get the books to close in an orderly way, accountants would like portfolio managers not to trade next week.

To a substantial degree, stock prices are driven by the earnings performance of the companies whose securities are publicly traded. But profit levels and potential profit gains aren’t the only factor. Stock prices are also influenced by investor perceptions of the risk of owning stocks, by alternating emotions of fear and greed, that is, that are best expressed quantitatively in the relationship between the interest yield on government bonds and the earnings yield (1/PE) on stocks.

discounting: fear vs. greed

Stock prices typically anticipate or “discount” future earnings. But how far investors are willing to look forward is also a business cycle function of the alternating emotions of fear and greed.

Putting this relationship in its simplest form:

–at market bottoms investors are typically unwilling to discount in current prices any future good news. As confidence builds, investors are progressively willing to factor in more and more of the expected future.

–in what I would call a normal market, toward the middle of each calendar year investors begin to discount expectations for earnings in the following year.

–at speculative tops, investors are routinely driving stock prices higher by discounting earnings from two or three years hence. This, even though there’s no evidence that even professional analysts have much of a clue about how earnings will play out that far in the future.

(extreme) examples

Look back to the dark days of 2008-09. During the financial crisis, S&P 500 earnings fell by 28% from their 2007 level. The S&P 500 index, however, plunged by a tiny bit less than 50% from its July 2007 high to its March 2009 low.

In 2013, on the other hand, we can see the reverse phenomenon. S&P 500 earnings rose by 5% that year. The index itself soared by 30%, however. What happened? Stock market investors–after a four-year (!!) period of extreme caution and an almost exclusive focus on bonds–began to factor the possibility of future earnings gains into stock prices once again. This was, I think, the market finally returning to normal–something that begins to happens within twelve months of the bottom in a garden-variety recession.

–the stock market decline we’ve seen since November is all about adjustment to lower future earnings growth prospects. This is being caused by the resumption of “normal” growth as the bounceback from deep recession is completed. Another aspect of the return to normal is the economic drag from gradual end to extraordinary monetary stimulus, at least in the US.

In Mr. Paulsen’s view, the S&P 500 can trade at 16x trailing earnings in this new environment, not the 19x it was at two months ago.

–we may have seen the lows for the year last Wednesday at midday (1812 on the S&P 500). More likely, the market will revisit those lows in the near future. It will break below 1800 on the S&P, creating a fear-filled selling climax.

–assuming, as he does, that the S&P will end the year flat, i.e. around the 2044 where it closed 2015, a buyer at yesterday’s close would have a 9% return (11% dividends) from holding the index by yearend. A buyer at 1800 would have a compelling 14% (16%) return. 11% might be enough to attract buyers; 16% surely will be.

–2017 will be a stronger year for earnings growth than 2015, implying that the market will rise further as/when it begins to discount next year’s earnings growth.

–the current selloff will trigger a market leadership change. The new stars will likely be industrials, small-caps and foreign stocks.

A double bottom marks a significant reversal in market direction. There are two possibilities:

–after a bear market, meaning a nine-month to year+-long market decline caused by a recession. (This is not the situation we’re in now.) The market typically bottoms six months or so in advance of what government statistics will eventually say was the low point for the economy. It does so partly on valuation, partly because the first anecdotal signs that the worst is over are beginning to be seen.

The market then begins its typical sawtooth pattern of upward movement, forming what technicians call a channel. This is an upward sloping corridor whose ceiling is formed by progressive market highs and whose floor is similarly formed by progressive lows. Initially, the slope can be quite steep. Day to day, the market makes progress by bouncing along between floor and ceiling.

–after a correction, meaning a decline of, say, 5% to 10% in market value that occurs over several weeks and which, in effect, adjust market values back from stretched to the upside to levels where potential buyers see the potential for reasonable gains over a twelve month period. (This is our current situation, in my view.)

Generally speaking, the same upward channel forms. But the slope may be very shallow. In fact, until new, positive, economic information emerges, there may not be much of a slope at all, so that stocks move more sideways than up. Nevertheless, in the case that the channel is almost completely horizontal, periodic successful testing of the bottom established at the end of the correction reinforces the idea that downside risk is limited.

Regular readers will know that I’m not a particular fan of technical analysis, at least as a primary tool in determining the investment attractiveness of the equity market or of individual stocks. A hundred years ago–maybe even sixty years ago–it was the tool, because there was nothing else. Before the SEC, company financials were a joke, and they weren’t easily available in a timely manner. Watching the trading patterns of the “smart money” was arguably the best an average person could do.

Nowadays, the SEC’s Edgar site has all US-traded companies’ filings available for free the instant they’re made. Most companies also have extensive libraries of their own available on their sites. Firms now webcast their earnings conference calls for all to hear. If you don’t feel like listening, transcripts are available for free soon afterward from Seeking Alpha.

So it isn’t so much that technical analysis is bad per se. It’s just that like the horse-drawn cart it’s been replaced by fundamental information that’s quantum leaps better.

support/resistance

Still, there are some aspects to technical analysis that I find useful. One is support/resistance. This is the idea that price levels where there has been significant past trading volume, preferably over an extended period, will act as floors to support stocks as they fall, as well as ceilings to impede their advance. Both holding at and breaking through these levels are often significant events. In particular…

double bottom

When the market has been declining for an extended period of time, or has dropped particularly sharply (the “magic” numbers technicians use are typically losses of 1/3, 1/2 or 2/3 of the prior advance), it often stabilizes for no apparent reason and begins a significant upward bounce (+10%?).

The fact that prices are now going up isn’t enough by itself to establish they have reached an important low. In almost all cases (March 2009 was, on the surface at least, a significant exception–see below), stocks begin falling again within a few weeks and find themselves approaching the previous low. If the market touches–or almost touches–the previous low but begins to rebound again (in the US, the market may briefly trade lower than the previous low–we’re daredevils, after all), this is often a strong sign that resistance is forming at the old low. This revisiting of the low is the necessary second part of the double bottom.

There can be a triple bottom, too. More often, in my experience, the market begins a new, upward pattern of higher highs and higher lows after the second bottom.

Fundamental conditions must also be in place for this bottoming to happen. Stocks have to be cheap; investor pessimism must be high; the downtrend must be protracted enough for at least some investors to think that conditions won’t get worse.

In essence, what the double bottom tells us is that intense negative emotion that has been driving prices sharply (often irrationally) lower has begun to play itself out.

current examples

Double bottoms happen with individual stocks and stock groups, too.

Look at the Macau casinos traded in Hong Kong. Some, like Galaxy Entertainment, have lost half their value over the past ten months. But the group appears to have bottomed in late September-early October. The stocks bounced off their lows, returned near them several weeks later and appear since then to have established a new upward pattern.

I haven’t looked carefully at energy stocks–but the oils are a group where I’d be looking for similar behavior.

the March 2009 case

The S&P 500 appeared to me to be bottoming in early 2009. As is usual during recessions, government programs were being put in place to stop the economic bleeding. Anticipating this, investors had pretty much stopped selling. However, in late March investors were horrified to hear that Congress failed to pass the proposed bank bailout bill/ Some (Republican) Representatives were even saying they would prefer a rerun of the Great Depression to a bank bailout. The S&P fell more than 7% on the news, but recovered all its losses when the bill was passed the following day. If we erase those two trading days, early 2009 exhibits a “normal” bottoming process.

Commentators often use sound-bite definitions for economic and stock market phenomena. For example,

–a recession is two successive quarters of year-on-year GDP decline.

–a correction is a short, counter-trend, fall in stocks of 5%-10%.

–a bear market is a fall in stock prices of 20% or more.

The virtues of these definitions are that they’re brief and unambiguous. On the other side of the coin, brief and unambiguous doesn’t represent real life that well.

adding complexity, but also relevance

There’s a time aspect to corrections and bear markets.

A correction typically lasts a few weeks. That’s because it’s normally a valuation issue–that “animal spirits” have pushed stock prices higher than near-term earnings can comfortably support. Short-term traders sell, but intend to repurchase in short order, hopefully at somewhat lower prices.

Bear markets, on the other hand, come in two types. Both anticipate–and ultimately reflect–widespread economic weakness that will last for a year or so. The garden variety is a consequence of governments’ countercyclical fiscal and money actions when economies are about to overheat (too bad Mr. Greenspan forgot about this part of his job).

The really deep ones come from one-time shocks to the system. In the past, these have been “external shocks,” like huge oil price rises. The most recent is the self-inflicted wound of the financial meltdown. As we experienced in 2007-2009, these ones are deeper and longer.

for the record…

…I don’t think we’re in a bear market–at least not in the world outside the EU (where stocks have already lost over a third of their value since May).

I think we’re in an unusual situation of correction in world markets, complicated by the EU situation. In brief, the EU hoped to get away with not rebuilding its banks’ strength after the losses they took in the financial crisis, but hiding them instead. They figured they could free-ride on the economic coattails of China and the US instead and use worldwide growth to mend.

Then the Greek crisis came. And, instead of addressing the fact their gamble had failed, EU governments have spent the last year with their heads in the sand, letting the problem get worse.

why bring this up now?

EU stocks have lost over a third of their value since May. US stocks are down by almost 20% (the “magic” bear market line). Metals prices are crashing. Stocks have been extremely volatile.

Monday morning I saw a lot of crazy stuff when I turned my computer Monday morning.

–European markets were down 5% intraday.

–Hong Kong-traded Ping An Insurance (I own it–ouch!) had lost another 8%+. It was down by 25% in three days on rumors that HSBC was about to sell a portion of its holding (so what, I say).

–AAPL lost $10 in early trading in a rising US market on a report out of Taiwan that orders for iPad components from Hon Hai for the December quarter were lower than expected. It turns out the orders, if they are indeed being lost at Hon Hai, are most likely going to a new iPad factory that’s opening in Brazil in December. It could equally be that AAPL is preparing for iPad3, which would be a bullish sign, I think. But, noooo. Traders took the most bearish interpretation.

The world isn’t 5% better one week, 6% worse the next, and 7% better the week after that. Economic processes don’t change that fast. Human emotions do, however. And the extremes of emotion we’re seeing now typically signal significant turning points in market behavior. Hence the title of this post.

what to do

My best guess is that we continue to move sideways in markets ex the EU until European governments address their banking crisis. They markets probably rally. But that may not be for a while, so don’t bank on that.

I think the best strategy is to use days of crazy selling as a chance to buy stocks that are being irrationally sold down. Be very picky, though. Look for high quality names where you’re very confident about the fundamentals. And don’t bet the farm on a single stock.

On September 6-9, for example, I bought INTC, because I saw it was trading at under $20 a share, or less than 9x earnings, and with a dividend yield of 4.3%. As/when it reaches $24, I have to decide whether I keep it.

if it’s a bear market, then what?

Then markets are not turning up again until maybe next summer. And, if past form holds true, we’ll see at least one more downdraft in stock prices–maybe another 10% from here, more in economically sensitive stocks and in emerging markets securities (even though the emerging economies themselves may be fine). That will come as government statistics and company reports show economic activity dipping into negative territory. Yes, world stock markets may have begun discounting this possibility. But, ex the EU, they’re barely begun to, in my view.

As much as it cuts against the grain of my growth stock temperament, it seems to me it’s worthwhile thinking about asset allocation and how you’d act if a more ursine mood begins to make itself evident on Wall Street. My portfolio is betting against this, but it never hurts to think about what happens if you’re wrong.

Market tops are harder to define, and to recognize, than market bottoms–at least for me. That’s partly because tops don’t all exhibit the set of common characteristics that bottoms do.

signs of a bottom…

Bottoms occur when stocks are priced at low enough levels that it’s hard to imagine a likely state of affairs that would justify where they’re trading at. Clear signs of bottoms include:

–stocks trading a deep discount to book value, or

–the dividend yield on stocks higher than that on government bonds.

…don’t work in reverse for tops

The opposite indicators for book value or dividend yield don’t work at market tops.

Why not?

Book value doesn’t matter much for service companies, which are nowadays typically the bull market stars. Accounting rules force service companies to charge expenditures on intangibles like R&D against current income, instead of putting them on the balance sheet and slowly writing them off. As a result, the concept of the balance sheet “book” value has limited relevance for them. A software company trading at 4x book value is much different from a steel company trading at 4x book.

Also, the fact that long Treasury bonds were yielding 10% in mid-1987, a time when stocks were trading at 20x earnings and yielding, say, 2%, clearly warned of the crash to come in October. But that was an unusual situation. During my career, many bull markets (I’ve seen five of them in the US and a larger number overseas) have been driven by some overarching theme. They’ve extended into an “emperor’s new clothes” kind of overvaluation and ended when the fantasy-like nature of valuations has been publicly exposed. But the stock indices have rarely shown up as wildly expensive vs. bonds.

a list of bull markets

To illustrate this point, these are the bull market endings in the US that I’ve lived through as a professional investor:

1981 bull market driven by oil stocks as OPEC demanded higher prices for its output, and by fear of runaway inflation, which focused investors on tangible assets. Bull market ended when spot crude prices peaked in late 1980 and began to fall. Soon after, Volcker Fed began to raise rates aggressively, adding to downward pressure.

1987 bull market ends on valuation, with stocks at 20x expected earnings, an earnings yield of 5%; bonds were trading at half that level, a coupon yield of 10%.

2000 really two themes, maybe two bull markets without a bear market in between. The upturn in 1992 was sparked by the realization that the American industrial base had been modernized/revitalized during the junk bond era of the Eighties and was earning much more than almost anyone expected. That phase was followed by the technology and Internet boom that lasted from 1996-early 2000. The latter boom was intensified by Greenspan’s aggressive expansion of the money supply. He did this to mitigate the effects of the Asian financial crisis and in fear of adverse Y2K effects that never materialized (thanks, Ed Yardeni!). The bull market ended when new orders for internet-related hardware suddenly stopped coming in during late 1999.

2006 bull market fueled by housing bubble and belief that finance was the new area of US competitive advantage. The bull market ended when homeowners began to default on mortgages they couldn’t afford to service. The boom was subsequently shown (to my satisfaction, anyway) to have been based on massive systematic fraud by financial companies, abetted by widespread incompetence and neglect by government regulators.

what do they all have in common?

The obvious thing is that they all ended badly. But the main point is that they don’t have the cookie-cutter identity of bear market bottoms. Instead, they have a kind of “family resemblance,” where some–but not all–of a set of several characteristics are evident. Among the things to look for are:

time

Yes, as a bull market matures, the discounting mechanism begins to cause today’s stock prices to reflect possibilities that are farther and farther in the future. This is in itself a warning sign. But it still takes time for positive economic events to play themselves out and for storm clouds to appear on the horizon. If a bull market is dominated by a theme, like oil or the internet, it also takes time for the theme to be recognized and played out to the extent that the major stocks are significantly overvalued.

A bull market typically lasts for well over two years. The up market(s) of the Nineties lasted for seven.

waves of speculation

The earliest days of a bull market are typically marked by outperformance of large-cap names, as investors scramble to move big amounts of money back into stocks. After this period, however, investor interest turns to small-caps. This is particularly true in a thematically-driven market.

Interest then shifts in progressive waves from small-caps to mid-caps, then to large-caps and finally in a highly speculative way back to small caps. These may be the same small caps the market was interested in earlier in the bull phase or they may be fresh IPOs. But the new focus is typically on aspects of the businesses that are purely potential, that may never come to fruition or will not make money for years.

Technicians have historically remarked on this final phase, where market breadth narrows, as one of divergence between small-caps and large-caps, which are beginning to break down. But I think the highly speculative element is key.

Yes, this indicator appears to be the bell ringing kind that alerts us to the top of the market. But, during the Greenspan era at least, this warning period has easily lasted a year or more. So there has been a substantial risk to professional managers, even if they recognize the sign, if they become defensive too prematurely.

qualitative cracks in the thematic vision

A theme-driven bull market, like any good individual growth stock, has, in addition to its quantitative underpinnings, a qualitative “story” element behind it. In my experience, threats to the theme always emerge first on the qualitative side.

For example, the late Seventies oil-driven market assumed that demand for oil was insatiable. At the time academic economists were coming out with theories claiming a special nature for oil–that it had a “backward-bending” nature which made demand increase as prices rose. Yes, that sounds crazy now, but academic journals were publishing articles about this new “discovery.” At some point, though, people elected to conserve–to turn down the thermostat, take public transportation and buy heavier clothes–rather than pay sky-high oil prices.

Similarly, as the internet boom matured, companies began to find ways to make existing data transmission lines carry more capacity (rapid development of deep wave division multiplexing) so that they didn’t have to spend so much on new lines.

These qualitative indicators of impending trouble are always there. They tell you nothing about exact timing, but they do serve as a warning to be on your guard.

stumbling blocks to recognition

Bull markets only come along once or twice a decade. That’s not very often. In addition, the Greenspan monetary philosophy encouraged the creation of speculative bubbles, making it harder to figure when, or at what levels, stocks should be peaking. (A Heideggerian might say that we refuse to recognize patterns that develop only over long periods because they remind us of our mortality (sorry!).)

But there are also more practical stumbling blocks. In particular,

–research reports from brokerage houses are relentlessly positive. Neither brokers nor analysts make money by telling clients to sell. In fact, they may lose business by doing so if they anger company managements or large holders of a stock they express a negative opinion about.

–the reliance of institutional clients on third-party consultants to select and evaluate managers has had two relevant results– ever higher specialization of portfolio managers, and the prohibition of “style drift,” or movement away from the areas the manager knows best. So today’s institutional manager may not pay much attention to relative sector valuation. It may make no sense for him to hunt for undervalued parts of the market outside what has worked for him in the past, because he won’t be allowed by his clients to invest in them.

–he won’t be permitted to raise cash either, because of the strong institutional emphasis is on relative performance rather than absolute. In consequence, if a manager doesn’t see anything but overvaluation in the areas he has been hired to invest in, his only choice is to give back the money. That made Warren Buffett’s reputation a half-century ago, but not many people have been willing to follow his lead. Why? …they forfeit management fees, and they have no guarantee they’ll ever get the money back.

The result of all these factors is to create a situation where a professional portfolio manager tends not to pay enough attention to, or to underestimate, how frothy the market may be at a given moment.

tops can last a long time

Rarely, bull markets have a “melt-up,” a buying panic that’s the same kind of definitive signal of the top that a selling panic, or meltdown, is of the bottom. More often, though, a bull market top lasts through months of basically sideways action. It’s as if you have a great seat at the movies and the film is terrific, but you smell a whiff of smoke. You know someone will eventually yell “Fire!’ and all hell will break loose. But in the meantime, it’s such a good movie and you have such a great seat that you decide not to leave.

for us as individuals

Three comments:

1. We have none of the restrictions, or the blinders, of institutional investors. We can afford to give up some of the upside to protect our downside. We can leave the theater.

2. There’s a temptation to focus solely on the overvalued sector and to argue that while doom impends there, the rest of the market is safe. That’s almost always a mistake. When the bull market ends, everything goes down. The decline in overvalued stocks tends to drag everything else down with them. Occasionally, as was the case with very defensive stocks during the collapse of the internet bubble, some sectors may show absolute gains. In most cases, however, their performance is relatively good but bad in absolute terms.

3. Up until the past decade, post-WWII bull markets in the US have typically lasted about 2 1/2 years. Bear markets have lasted around 1 1/2. Together, the two make up the typical inventory adjustment or “electoral” market cycle.

Arguably, then, the bull is beginning to live on borrowed time when an up market enters year three. Similarly, a bear market is starting to be on its last legs when the decline enters year two. A reasonable strategy would be to begin to look hard for signs of reversal once those mileposts have been achieved.

Neither rule of thumb would have done much good so far in the 21st century. The bust that followed the internet bubble dragged on from April 2000 until March 2003. The housing-driven bull market that followed lasted four years, until mid-2007.

It’s possible, however, that with Mr. Greenspan out of the picture and with “bond vigilantes” on higher alert that the older patterns may reemerge.

(Note: I’m editing and updating this in March 2012, in response to a reader’s comment. The bull market that began in March 2009 endured a sharp correction of about 20% last summer. That was right on the old schedule. However, prices have since rebounded and are retouching the old highs. And the intrusion into financial markets by governments in the developed world–with the EU and Japan joining the cheap money party–is greater today than it has been over the past several years. So the timing of the 2011 correction may have only been coincidence. Personally, I think we may continue to be winging it for a while–at least until the shape of post-election fiscal policy in the US becomes clearer.)